Tax considerations for person expecting to inherit a parent's house

Benny Kass

Published 4:00 am, Sunday, November 11, 2007

Q: Will the real estate tax rate increase if I inherit my father's house? My dad said it might not if I take the home as a distribution. I am currently living in the house, which is under his name. My concern is that when I have the option to purchase the home, the tax rate will go up, but it may not if I inherit it by this distribution.

A: I think you are confusing different kinds of tax situations. The real estate tax that you pay to your county or state is normally based on the value of your property. This decision is generally made by a government assessor in the real estate tax office where the tax is paid.

Another tax is called the capital gains tax, and this is calculated on any profit that you may make when the property is sold.

Let's take this simple example: Your dad bought the house years ago for $100,000 and it is now appraised at $500,000. Assume for this discussion that no improvements were made to the house. For IRS purposes, the agency looks to what is known as the tax basis of the property, and in our example, the basis is $100,000. (If improvements were added to the house, that would increase the tax basis.)

If you buy the house now from your father at the market price of $500,000, two things will happen. First, your father may have to pay capital gains tax on the profit he has made - in our example, $400,000. (However, if he has lived in the house for two out of the five years before it was sold, he can exclude up to $250,000 of this gain - or if he is married and files a joint tax return he can exclude up to $500,000.)

On the other hand, if you inherit the property on your father's death, which is what you refer to as distribution, you will get what is known as the stepped-up basis. This means that the market value of the house on the date of death will become your tax basis. So if the value is $500,000 when he dies, and you immediately sell it for that same amount, you will not have to pay any capital gains tax.

Second, I suspect that the real estate tax division in your county or state will want to increase the assessment up to your purchase price, which means that it is very likely that your real estate tax will increase. The real estate tax is based on the value of the property; it has nothing to do with how you take title to the house. In California, however, the transfer of a property from a parent to child is generally exempt from reassessment.

By the way, in my opinion, it is not a good idea for your father to give you the house now. Under the tax law, the tax basis of the donor (the person giving the gift) becomes the tax basis of the donee.

So in our example, if your father gives you the house, your tax basis would be $100,000. If you decide to sell now for $500,000 - and have not lived in the house for at least two years - you will have to pay capital gains tax on $400,000. The tax rate to the federal government for most people is 15 percent, which means that you will have to give Uncle Sam $60,000, plus pay any applicable state and local income tax.

That's a lot of money.

Q:What is the most direct and effective way to begin to invest in mixed-use real estate properties and development projects?

A: The very first thing I would do is to get three professionals on board: a lawyer knowledgeable about real estate; a real estate broker with investment property experience; and a lender.

The lender is perhaps the most important person and the one you should talk to first. You want to make sure how much you can afford to buy and how much the bank is willing to lend you. Keep in mind that while this may be a good time to buy - because of the current housing situation - lenders are now very cautious and extremely conservative, especially when the loan involves investment property.

Map out a plan with your attorney and the real estate broker. What kind of properties do you want to buy - single-family homes, condominiums, office or apartment buildings? Your advisers will be able to guide you in the right direction, but they need your input as well as confirmation of your financial ability to buy.

Your real estate agent/broker should be able to advise you on the rental situation in your area. Obviously, if the vacancy rate is high, unless you get a very good discounted price for the property, you may be losing money on a monthly basis, and your lender will steer away from this investment.

My advice: If you are a novice in the field of real estate investment, buy properties in your area. I am old-fashioned enough to want to touch, feel and monitor any properties that I own.

Q:My partner and I have been together since 1995. Is there a way that an unmarried couple can take advantage of the up-to-$500,000 exclusion of gain on the sale of the house? We file separate tax returns, and the house is titled in my name only.

A: I have bad news for you. In order to take advantage of the up-to-$250,000 exclusion of gain, there are three requirements: You must own the house for at least two years; you must have lived in the house as your principal residence for at least two years; and during the two-year period ending on the date of the sale, you must not have excluded gain from the sale of another home. The first two tests are referred to as the ownership and use tests.

In your case, you are the sole owner of the property, and thus only you can take the exclusion.

However, if you put your partner on title, and the two of you then live in the property for two years, if you both meet the three tests, you can both exclude up to $250,000 on your respective income tax returns.

If you decide to go the route of putting your partner on title, discuss the tax ramifications with your tax adviser.

For more information, go to the IRS Web site and click on Forms and Publications. You want Publication 523, Selling Your Home.

Q:My father-in-law died a couple of years ago. Because of various emotional and financial reasons, my husband and I are just taking or trying to take over the house. It needs a lot of work, but we can't apply for any assistance until the house is in our name. How should we go about getting that done? My husband and I also live there now.

A: The first thing you must do is to confirm that the real estate taxes and any mortgage obligations have been paid. The next thing you should do is hire an attorney in your state who has experience with probate.

The state where your father-in-law died will normally be the place that has jurisdiction to handle the probate of his estate. I do not know where your father-in-law died, so I will have to give you a general answer; your lawyer will be able to give you the specific answers for your state.

Generally, when a person dies, his or her property will automatically be vested (go into title) into the personal representative, or PR, also called the executor in some states. However, until a probate case is opened, there is no PR. When you open the probate estate, the court will appoint the PR.

If your father-in-law had a last will and testament, that document will most likely name the PR your father has selected. If there is no will, the court will have to decide who will be appointed. The court will appoint a family member unless there are disputes among the family, in which case the court will appoint an outsider - usually a local attorney knowledgeable about probate law.

Once the PR is on board, title to the property will be in his or her name. Usually the PR must put creditors on notice of the death, so as to give any creditors the opportunity to file claims against the estate. From my experience, this is done by advertising a number of times in a local paper of general circulation. After a period of time - six months in the District of Columbia, where I practice law - creditors can no longer file any claims against the estate.

Once the creditors (if any) have been paid off, the PR can convey the house to you and your husband. However, if your father-in-law had debts that exceeded his assets, the house may have to be sold to satisfy those debts. In this case, you and your husband can, of course, purchase the property from the PR by coming up with enough money to satisfy the debts of the estate.

Obviously, this is very general. Your probate attorney will guide you through the process. But it is important to act quickly; you have already waited too long.

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